An Example of Ineffectual Competitive Response- Part Two

Earlier this week, I wrote about a local example of ineffective competitive response to a new market entrant.

Throughout the past few years, I've written many pieces on the inevitable demise of GM, but that's a global- and national-scale story. In the case of the local fitness club, I am fascinated by the operation of similar principles, but on a much smaller, totally observable scale.

In the prior post, I detailed some of the history of my old fitness club. How it began, what crucial decisions the owners made which cast their future options in stone.

The current attitude of the owners is summed up in the notion expressed in their recent letter to members,

"We are small enough to know you and large enough to serve you."

Unfortunately, that's only the demand side. What about the supply situation? That is, the financial realities of operating such a facility?

Fitness clubs have a fairly high proportion of fixed to variable costs. The building must be opened, heated/cooled, lit, towels washed and water provided, the facility cleaned. A few people are needed for administrative purposes, and to conduct various classes. But for the most part, the daily costs of running such a club are pretty constant, whether 20 or 200 people use it that day.

Based upon the known membership size as of the middle of last year, the pricing plans, and the number of higher fee-paying squash members, the revenue for the club in a recent full year of operation was probably something in the neighborhood of $3-3.3MM, including some estimate for personal training revenues, which vary by membership size.

From various sources, including a rough count of the number of former members of the old club appearing at the newly-opened LifeTime Fitness club, it has been estimated that about 10% of the members of the old club have switched to the new one. Most of those who switched play squash, thus representing the highest-margin members at the old club. Since LifeTime Fitness has a single fee per person, rather than charging extra for using various parts of their club, this was one of the attractions of the new club to many squash players from the old fitness club.

If one assumed a fairly standard profit rate of 10% on sales, the old fitness club probably earned a pre-tax income for its owners of something in the range of $300-330K annually. But with so many of its higher-paying members gone, some of my more financially-savvy friends and myself have estimated that this has now dropped to near breakeven.

We may be off by a few percentage points, but, from the standpoint of an external consultant, the direction of the changes, and their relative magnitudes, are fairly clear. If you were given the job of managing my old fitness club, you'd have a considerable challenge on your hands.

For instance, you've probably lost almost 10% of your revenues, but your costs are still pretty constant. Furthermore, in less than a month, a second LifeTime Fitness club will open a few miles away, taking perhaps another 50-100 members, or another 3-6% of the original member base.

Because the club's membership loss comes from a new entrant, it's unlikely that many new members will be joining the old club. Those that do will probably fit a rather narrow profile: 30+, single or married, living very near to the facility. Otherwise, those with families or more distant will find one of the two LifeTime Fitness clubs a better economic value while being no further away.

If the old club attracted as many as 50 new members per year, it's reasonable to assume that would fall to no more than perhaps 10-20 now. And those are unlikely to be the higher-priced squash members.

Thus, revenue and profit growth for the old club are now limited. A manager's next move would be to cut expenses. Since desk and other low-paid, part-time workers are necessary and provide little in the way of profitability improvement, the only reasonable alternative is to either cut the higher-paid activities staff, or move them to the same basis of compensation as LifeTime Fitness employees, i.e., a heavy incentive component based upon member involvement.

The owners of my old club are very successful, accomplished, likable older men. Having owned and operated the club since 1978, they are not looking toward additional decades of involvement in the facility.

So, if you were a consultant hired to advise them on alternatives, you'd know that, whatever money they were making prior to the entry of LifeTime Fitness into the local market, they will probably never make that much profit again. New member growth is unlikely. Raising prices even higher above LifeTime's levels will probably drive even more members away. Cutting prices will, of course, only result in member retention with less profit. Moving some of the program-related employees, such as the aerobics program director and various class leaders to variable compensation, will only result in a one-time drop in expenses.

Thus, from the supply side of the fitness club's financial equation, it's unclear whether it can prosper by fulfilling its stated objective.

In more graphic terms, it's unclear that a collection of aerobics class-using housewives, older, retired couples and some locally-residing members, all of whom value the club's proximity and friendly, small environment, can ever provide the prior level of profitability, or even a breakeven level of profit.

I would wonder how long the current owners can afford to fund the lower level of profitability. If there were a competitive environment in which the owners of the old club could add programs, facilities, or cut prices, they might hope for a return to the prior level of profitability. But this isn't really feasible anymore.

Like GM, though on a much smaller scale, one wonders how long managers and/or owners of an enterprise can afford to be in denial about financial realities facing them in the future?

I guess, for my old fitness club, it's a function of how long the owners choose to fund a less-profitable, and perhaps even losing enterprise, than they had in the past. Unfortunately, good intentions and prior accomplishments don't necessarily count for much when a more economical, fully-featured competitive facility enters the market.

Thirty years is a very long time for a relatively static business enterprise to have survived and prospered. Ceasing operations under these circumstances wouldn't mean a failure of the business, so much as a change in the competitive environment, and market, which the older club is simply unable to profitably address any longer.